Putting Passive Inflows Into Context

John Authers from the Financial Times had a great story last weekend on state of the fund management industry. This chart garnered a lot of discussion on social media:

Passive I

These things are cyclical, but the recent trend is clear as investors are pulling money from active, stock-picking funds and moving their cash to passive funds. This year could be the tipping point as active funds have had one of their worst years ever:

Passive II

Some active managers see these statistics and their first instinct is to get defensive. A UK consultant quoted in Auther’s piece did just that:

However, the problems of active managers create dangers. Somebody has to do the job of “price discovery”, or setting a sensible price for shares, so that capital will be efficiently allocated to where it can be of most use. Index funds, which merely accept whatever prices are on offer, do not do this.

Mr Rajan predicts that the trend towards passive will eventually reverse. “The more money that goes into passives, the more they will become dumb,” he says, and prone to massive overshoots. He adds that active managers’ problems have been in large part caused by central banks, which have intervened to stop share prices correcting on several occasions. Indexing, he says, has also helped fuel investment bubbles; new money coming into tracker funds is automatically allocated to the companies with the highest market value.

“I can’t believe that this amount of money going into passives isn’t going to have an impact,” he says.

Placing blame on someone or something else is a time honored tradition in the finance industry. Why take responsibility for a poor stretch of performance when you can blame the Fed or mom and pop investors?

I love the argument that passive investing is going to cause bubbles. Like we never had bubbles before index funds? Unfortunately, these are just more excuses being made for underperforming the market. While the inflows into passive and the outflows from active are impressive, you can’t make any market-altering judgments without putting these numbers into context. Passive is still a drop in the bucket when it comes to overall market allocations.

Via The Economist, Price WaterHouse Coopers performed a study that shows passive investments currently make up roughly 11% of the global fund management industry. PwC forecasts that it will double by 2020, a huge growth trajectory for sure, but that would only bring it up to 22% of the total:

Passive III

Plus, there’s a good chance that once active managers have a good year that the Johnny-come-lately-passive investors will change course and chase performance.

The investors from the old guard that are fighting this shift to ETFs and more passive investing models are going to continue to fall by the wayside. Authers summed up his FT article nicely:

So the chances for an active renaissance at some point look healthy. But the traditional model of active management is doomed. In the future, active managers will find it hard to attract investors’ money, unless they can show that their investing is truly “active”, and their fees are as low as they can be.

I hope this is the case, but I think it’s going to take some time. Although, there actually is a model for active funds that’s working beautifully even during this period of active underperformance — Vanguard. It’s just that the industry is trying to squeeze everything they can out of the dated high fee system that’s been in place for far too long to follow their lead.

According to Reuters, 20 out of the 30 active stock funds at Vanguard outperformed their benchmarks over the past three years. And they did so by an average of 1.1% a year, a fairly wide margin in an increasingly competitive marketplace for alpha.

There are two simple reasons for this outperformance:

(1) The fees are dirt cheap, averaging just 0.41% for Vanguard’s active funds versus the industry average of 1.25% for all actively managed funds.

(2) Vanguard has a loyal client base that thinks and acts for the long-term just like their investment managers (see: Learning From Vanguard Investors).

Active management can work. It just needs to be the right kind of active. It has to be different, low cost and transparent.

If I had the chance to invest directly in any segment of the fund industry to place a bet on its future growth it would be the low-fee, active ETF space, without question. I think there is an enormous opportunity for intelligent, low-cost, low turnover, tax efficient, evidence-based active strategies to gain huge market share from the current crop of closet index funds.

The old guard will continue to make silly arguments about the Fed and how passive investing is going to lead to instability in the markets while their market share slowly dwindles. In the meantime, up-and-coming ETF providers and places like Vangurd that actually get it will be more than happy to take their place.

In a perfect world this process would happen very quickly. Technology could speed it up, but investors have to continue to make smart choices and pull their money from overpriced closet index funds.

Sources:
Investment: The Loser’s Game (FT)
Will Invest For Food (The Economist)
Vanguard stockpickers outperform despite firm’s passive push (Reuters)

Further Reading:
Blurred Lines Between Active and Passive Investing

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  2. Jim Haygood commented on Dec 24

    From the Reuters article: ‘the $13.8 billion Vanguard Capital Opportunity Fund has outperformed the S&P 500 index by 6.5 percentage points a year for the last three years.’

    Reuters’ claim doesn’t seem to be quite right, which is why I never believe anything from the financial press without independent confirmation. Vanguard’s site (presumably authoritative) shows just under 5% annual outperformance in the past 3 years. But it’s still surprising.

    https://personal.vanguard.com/us/funds/snapshot?FundId=0111&FundIntExt=INT

    How did the fund do it? Simple. Put two-thirds of the weighting into Health Care (lots of biotechs) and Technology. Those sectors won; so did the fund. But in some earlier years, it underperformed.

    For funds such as VHCOX, the questions raised are: (1) Are its sector tilts systematic or discretionary? (2) Is its performance consistent enough to indicate skill or merely luck? (Hard to tell without 20 years of data.)

    I like tilting at sectors — it beats tilting at windmills. But I’d prefer to do it myself.

    • Jim Haygood commented on Dec 24

      Clarification: the fund’s benchmark is the Russell Midcap Growth index, which it beat by about 5% annually.

      Reuters may be correct about it beating the S&P by 6.5%, but that’s comparing mid-cap tangerines to large-cap oranges.

      • Ben commented on Dec 24

        I honestly think that most active managers could prove their worth more by making big sector bets instead of trying to pick the best stocks within each sector and keep their sector weights fairly inline with their benchmark. But, like you said, it depends on how the asset allocator feels about those kinds of bets and whether or not they can do them better themselves.

        I actually think that’s the problem with most professional investors — they try to leave the asset allocation decisions up to the specialist managers which never works because those types of funds always think it’s a good time to invest in their space.